Today in corporate tax avoidance: Caterpillar's 'pink elephant'

Ready to excavate a hole in the tax code: A Caterpillar earthmover at work at a Utah coal mine.

Ready to excavate a hole in the tax code: A Caterpillar earthmover at work at a Utah coal mine. (George Frey/Bloomberg)

Michael Hiltzik

Forget about jazz; the true indigenous American art form is the tax dodge. Today brings us (courtesy of Sen. Carl Levin's subcommittee on investigations) an impressively elegant example from Caterpillar Inc.

Elegant and lucrative too: Levin's committee says Cat's maneuver has saved it $2.4 billion in taxes since 2000. On the downside, the company had to pay PricewaterhouseCoopers, which cooked up the dodge as Caterpillar's tax consultant and also approved it as Caterpillar's corporate auditing firm (this is known as one hand shaking the other), a fee of $55 million.

The Caterpillar case, which will be aired at a Capitol Hill hearing today, is part of a series of investigations of corporate offshore tax avoidance issued by Levin, a Michigan Democrat.

Levin's most noteworthy previous hit involved Apple, which vested a large portion of its intellectual property rights in an Ireland affiliate that supposedly accounted for 30% of the company's profits. By exploiting the cracks between the tax rules in Ireland and the U.S., Apple avoided paying tax to any country on those profits. Levin calculated Apple's tax savings from that arrangement and a few others at $7.7 billion in 2011 alone.

By that standard, Caterpillar is a piker. But it's also about one-third Apple's size, so it should get credit for trying harder.

According to the subcommittee, the Caterpillar dodge concerned spare parts the firm kept in its U.S. warehouses, including a giant depot in Morton, Ill. The parts were destined for shipment worldwide, in a side of the manufacturer's business that provided a much higher profit margin than the selling of bulldozers and backhoes, and as much as 80% of its profits.

Typically, these parts sales were subject to U.S. tax. But in 1998, PricewaterhouseCoopers devised a plan to cede ownership of these parts to a Swiss partnership named CSARL.

As the arrangement was described by Reuven Avi-Yonah, a University of Michigan tax expert scheduled to testify at today's hearing, when parts were destined for U.S. dealers, CSARL would turn them over to Caterpillar at no profit, and CAT would report the sale to the dealers to the IRS. If they were for overseas dealers, CSARL would book the sale as its own, and it would be reported only to Swiss authorities, who charged CSARL (that is, Caterpillar, wink wink) a tax rate of only 4% to 5%.

The only change was bookkeeping. The parts were shipped in and out of Morton, as before. Caterpillar still handed the shipping, as before. CSARL had no warehouse of its own, in Switzerland or anywhere else. Its parts weren't even physically separated from others in the Morton facility — they were even kept in the same bins, and just distinguished by a computer entry.

At least one executive in Cat's tax planning department questioned whether the new arrangement would pass muster with the IRS, which frowns on maneuvers designed only for tax avoidance. The executive, Global Tax Strategy Manager Daniel J. Schlicksup, called the lack of a business rationale "the pink elephant issue worth a billion dollars on the balance sheet." Schlicksup claims his career was effectively short-circuited at Cat after he raised the issue.

Caterpillar, in its own statement prepared for the hearing, says that it "complies with its legal obligations with respect to the payment of taxes." It calls CSARL "no mere shell" but "a true entrepreneur for sales of machines, engines, and parts in its territories." The fact that the restructuring of CSARL's role at Morton happened to affect the "U.S. taxation of the non-U.S. sales income" was just gravy, according to Julie Lagacy, the Caterpillar VP scheduled to testify; the real goal was to produce a "simpler supply chain."

Levin's previous investigations have shown that scams like this, in which income is arbitrarily designated as offshore to avoid U.S. taxes, are common. Estimates of what USC tax expert Edward Kleinbard terms "stateless income" earned by U.S. multinational corporations but untaxed, run as high as $1.7 trillion.

As we observed in connection with the Apple case, the easiest way to end them is to abolish the overseas income loophole in U.S. tax law: impose a single rate on all income earned by U.S. multinationals, with a credit for taxes paid to foreign countries. That would allow Congress to bring the statutory U.S. corporate tax rate down from the current 35% to about 25% to 28%, close to the effective corporate tax rate in other big industrial countries.

That's not the option that big business advocates, however. They say such abuses illustrate why the corporate tax should be abolished altogether. They also say that companies should be given amnesty on income previously undertaxed through these scams, and allowed to redesignate it as U.S. income without paying a penalty.

Nice try, fellas. How about this: let's require that all income on which this sort of tax magic was worked should be forfeited, permanently? That might end this sort of tax dodging for good, and do wonders for the U.S. deficit into the bargain.